Document Security Systems: Running Out of Time

| About: Document Security (DSS)

Document Security Systems (AMEX:DMC), a company built on overly-promotional deals and an unblemished history of financial failure, has recently announced several new operational initiatives as well as their second quarter 2008 results.

Unfortunately for shareholders, these appear to be the last gasps of a company whose days are limited.

(For an extensive background on the company, please see previous write-up here)

Yet Another Over-Hyped Announcement:

On 4/17/08, DMC announced an expanded agreement with the Ergonomic Group relating to DMC’s  digital security product. The Ergonomics group is controlled by Robert & Karen Girards, and is a large shareholder of DMC stock. In the press release, Patrick White (DMC’s CEO) was quoted, “It is increasingly clear that our customers are looking for software-based digital solutions that integrate our anti-scanning and anti-counterfeiting technologies into their existing systems and processes.”

The release also had the customary mention of sales presentations to, and demand seen from Fortune 500 sized companies. Given DMC’s history of over-promising and under-delivering, it should have come as no surprise that sales for DMC’s supposedly promising digital solutions technology, were only $16,440 in the first half of 2008, down from $174,771 in the first half of 2007 (note: these numbers are not in thousands). (See here.)

This deal also helped inflate DMC’s second quarter results. On 8/11/08, DMC announced that revenues had increased 71% year over year, with gross profits increasing 101% improving the quarterly gross margin to 61%. Unsurprisingly, the majority of the improvement related to $542,000 of previously deferred revenue from the Ergonomic Group being recognized in the quarter, and not actual sales.

The details behind the arrangement are located in the most recent DMC 10Q. Under a previous agreement with the Ergonomics Group, entered into on 2006, DMC had received $1 million in non-refundable license and royalty fees, of which $500,000 was recognized as royalty revenue over a two year period, and the other $500,000 was considered a pre-paid royalty. The prepaid royalty would be deferred, and recognized as royalty revenues when sales of licensed products were made by the Ergonomics group. The new agreement with the Ergonomics group on 4/17/08 replaced this deal, and canceled the old 12/29/06 agreement.

Apparently, sales of DMC licensed products by Ergonomics Group had been minimal, since $542,000 of the non-refundable royalty payments had yet to be earned and recognized by DMC. Since the old deal was no longer in effect, DMC was able to recognize all remaining unearned, non-refundable royalty payments from the old deal at one time. Amazingly, the inability of DMC’s products to sell in the marketplace helped produce a gain in recognized revenues. This action accounted for 59% of DMC’s revenue increase in the 2nd quarter.

Because this $542,000 in sales was a non-cash accounting gain, there were no corresponding cost of goods sold, distorting the company’s gross margin. Instead of the reported gross margin of 60.5% (a record for the company), DMC would have shown a gross margin of 47.7% without the one time benefit (the worst margin in over a year). (See here.)

A Failing, Unprofitable Business:

According to their most recent quarterly report, DMC had a cash balance of only $960,898 as of 6/30/08, down from $3,251,094 at 6/30/07. To remain solvent, DMC had to borrow $2,058,000 on credit lines provided by shareholders and agreed to sell $2 million in stock (at a steep discount to market prices) in the first half of 2008 alone. So far in 2008, DMC has had an operational cash flow burn of $1,637,075 or $272,845 a month.

On top of the cash burn associated with running a business with minimal real sales, DMC faces substantial legal expenses in 2008. DMC has classified patent litigation costs as investments in intangible assets under cash flows from investing activities, keeping these major expenses off of their income statement, and cash flow from operations. So far in the first six months of 2008, this line item has totaled $756,626, or $126,104 per month. 

Desperate Financings:

It appears that the only parties willing to lend to DMC are insiders or related parties seeking to prop up the overvalued shares they own. As mentioned earlier, in an attempt to prevent operational cash burn from taking the company under, DMC entered into two credit facilities on 01/4/08. The first credit line is provided by DMC’s Chairman, Robert Fagenson for $3 million, of which $1,408,000 had been borrowed as of 6/30/08. The other credit line is with DMC’s CEO, Patrick White, for $600,000, of which $450,000 had already been borrowed by 6/30/08. At the end of the second quarter, DMC had $1,742,000 remaining in available borrowings under the two credit lines.

To address legal cost concerns, DMC announced on 5/08/08 that they had found a partner to shoulder some of the cost of their patent litigation. DMC entered into a credit line agreement with a newly formed New York corporation, Taiko III Corp for a $500,000 line of credit at an interest rate of 6%. DMC’s chairman noted that they “have been approached by a number of sources interested partnering” with DMC, who “believe in the merits of our case.” Desperate for cash, DMC immediately tapped the line, borrowing $300,000 under the agreement the very next day on 5/09/08. No other information was presented in the press release on the new Taiko III Corp, however the name of Taiko’s president was revealed, buried in an 8-k filing on 5/12/08. Taiko’s president is none other than Robert (Bob) Girards, COO of The Ergonomic Group, a long time partner and shareholder of DMC. According to DMC’s most recent 10Q, the company has already exhausted this funding source, with borrowings under the line at the maximum $500,000 as of 6/30/08.

These life-support financings will only serve to delay the inevitable. Below is a breakdown of the major financial hurdles facing DMC in 2008:

*Working capital was calculated as current assets minus current liabilities, which resulted in a negative number.

Finally, on June 25, 2008 DMC entered into 2 share purchase contracts with Walton Invesco Inc agreeing to sell 500,000 shares for an aggregate purchase price of $2 million or $4 a share. This price represented a 20% discount to the closing price of DMC on 6/25/08. The terms were even more generous than first appearances since DMC only required Walton Invesco to pay $700,000 up front, with the remaining $1,300,000 to be paid over two years.

DMC’s largest shareholder, Charles LaLoggia, also sold 75,000 shares of stock to Walton Invesco Inc. on June 25, 2008 for $2.50 a share. DMC stock closed at $4.99 on 6/25/08, meaning Laloggia sold the shares for almost half the market price at the time. LaLoggia, like several DMC insiders, purchased his DMC stock for less than 20 cents per share. The current value of DMC becomes highly questionable when the company and its largest shareholder are selling stock at 20-50% discounts.

DMC has only $1.7 million remaining in available borrowings from their related party credit lines and $1.3 million cash to be received from stock they sold in July. DMC’s current market capitalization of $72.96 million is over 10 times trailing twelve month sales, a higher valuation multiple than Google (Nasdaq:GOOG).  For DMC, a company whose viability through another year is in doubt, any value over $0 placed on the shares could be too high.

Disclosure: Author holds a short position in DMC

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